Interest rates may need to climb as high as 5% to bring inflation under control, according to the National Institute of Economic and Social Research, which warned that both the Bank of England and Government are deferring difficult decisions that risk worsening economic pressures. NIESR forecast Consumer Prices Index inflation will peak at around 4.4% in February, up from the 3.8% peak it predicted in July. The Bank of England raised rates to 4% last week, the first increase in more than three years, but NIESR said even if the Bank raises rates one more time as expected, inflation would not return to the 2% target until late 2030.
NIESR's analysis suggests rates need to reach 5% to address the risk of second-round inflation effects, which the think tank expects to emerge early next year when companies set wages and prices. The Bank risks prolonging the crisis by delaying further action now, NIESR argued. The think tank warned that holding rates below the level needed will hit poorer households hardest, leaving them no choice but to buy less rather than adjust spending or use savings to cope with inflation.
The think tank also criticised the Government's fiscal strategy, arguing that major spending commitments on defence, social care and disability remain unfunded. Chancellor John Healey confirmed in last month's autumn Budget that fiscal headroom will fall to £14.5 billion from £23.6 billion, a reduction linked to higher debt interest costs. NIESR said the Government's plans to balance public finances depend heavily on restraining spending in the years ahead, but if those plans slip by as much as previous efforts have, the Government would miss its fiscal rules by around £30 billion. The think tank said the Chancellor missed an opportunity at the autumn Budget to put finances on a firmer footing, with difficult decisions about taxes and spending largely postponed.
On economic growth, NIESR forecast UK gross domestic product at 1.6% this year, stronger than its previous prediction of 1.4%, driven by Government spending and business investment. However, GDP is expected to slow to 1.1% next year, lower than the earlier projection of 1.3%.